Average Annual Return (AAR)

Posted on by user

Average Annual Return (AAR)

Average Annual Return (AAR) is a simple percentage measure that summarizes a fund’s or investment’s historical performance over a specified period (for example, three, five, or ten years). It aggregates the effects of share price appreciation, capital gains distributions, and dividends to give a single, easy-to-read figure investors can use to compare funds or evaluate past performance.

Key takeaways

  • AAR summarizes historical total returns (price change + capital gains + dividends) over a period.
  • The arithmetic AAR is easy to compute but does not reflect compounding or volatility.
  • The geometric mean (compound annual growth rate, CAGR) better represents compounded returns.
  • Use AAR alongside annual returns, CAGR, volatility, fees, and manager information for a fuller picture.

What AAR includes

AAR for a mutual fund or equity portfolio combines three main components:
* Share price appreciation — unrealized gains or losses from holdings as stock prices change.
* Capital gains distributions — realized profits from sales that are paid out to shareholders (reduces NAV when paid and may be taxable).
* Dividends — earnings distributed by companies; reinvesting dividends increases a fund’s compounded return.

How to calculate AAR

There are two common approaches:

  1. Arithmetic average (simple AAR)
  2. Formula: (r1 + r2 + … + rn) / n
  3. Example: Annual returns of +40%, +30%, −10%, +5%, −15% average to (40 + 30 − 10 + 5 − 15) / 5 = 10%

  4. Limitation: This treats returns as additive and ignores compounding and sequence effects, so it can overstate typical yearly performance when returns vary widely.

  5. Geometric mean (CAGR — reflects compounding)

  6. Formula: [(1 + r1) × (1 + r2) × … × (1 + rn)]^(1/n) − 1
  7. Example using the same returns: product = 1.4 × 1.3 × 0.9 × 1.05 × 0.85 ≈ 1.462.
    CAGR = 1.462^(1/5) − 1 ≈ 7.9%
  8. Advantage: Shows the annualized compounded return an investor would have experienced, so it’s generally more meaningful for long‑term comparisons.

Important considerations and limitations

  • AAR (arithmetic) does not account for compounding or the order and volatility of annual returns.
  • Capital gains and dividend distributions reduce a fund’s net asset value (NAV) when paid; tax treatment depends on the investor’s situation.
  • AAR alone doesn’t reveal consistency. Two funds with the same AAR can have very different yearly return patterns and risk profiles.
  • Fees, turnover, manager changes, and portfolio concentration materially affect realized returns and should be reviewed.

How to use AAR when evaluating investments

  • Treat AAR as one metric among several:
  • Compare with CAGR to understand compounding effects.
  • Check year‑by‑year returns to assess consistency.
  • Review standard deviation or other volatility measures.
  • Consider expense ratios, holdings, manager tenure, and historical capital gains distributions.
  • For long-term investors who reinvest distributions, CAGR (geometric mean) is usually the more relevant figure for expected growth.

Conclusion

Average Annual Return is a useful, straightforward summary of past performance, but it has limits. Use AAR to get a quick sense of historical performance, then dig deeper with compounded returns, annual return patterns, volatility, costs, and tax implications to form a complete view before making investment decisions.